~ Investment Strategy

Morning Note: More on JPY

First, will asset purchases and an inflation target in Japan cause JPY to weaken whatever happens to the two-year interest-rate spread — i.e. to break its past correlation. I do not think so.

1. The inflation target is not very credible. It looks very much like a sop to the politicians to keep them off the BoJ’s back. The BoJ doesn’t think it can do anything about deflation (which I think is probably wrong, but that is another story). This means that there has not been a sea-change in monetary policy that would cause a reversal in the long-term trend in JPY. The upward pressure on Japan’s exchange rate as a result of deflation is unlikely to abate.

2.1. If we leave aside the weak de jure change and focus on the de facto change, the situation is a little more complicated. A chink has clearly appeared in the BoJ’s armour and politicians are clearly keeping the inflation/deflation issue at the top of the agenda. This raises the probability that Japan will eventually cure its deflationary problem. This way of looking at things is supported by breakeven inflation, which remains subdued at the 4-year point but has recently turned positive (continuing an upward trend of several months’ duration) from the 5-year point. I do not know the reason for the uptrend — presumably the BoJ’s actions after the earthquake and tsunami are an important part of it — but let us assume that the recent sharp move above 0% from the 5-year point onwards was caused by the BoJ’s announcement.

2.2. In order to understand what the effect of this will be, we need to know a bit about economics in a liquidity trap. One way of thinking about a liquidity trap is that the economy has been so damaged that the rate of interest that would restore full employment is presently negative. Because central banks are unable (or possibly just unwilling) to cut nominal rates below zero, the economy remains depressed. One way out of this problem is to cut the real interest rate by raising inflation expectations while keeping nominal rates anchored. This policy has been effective in the US: as various monetary-policy actions have raised inflation expectations, real interest rates have fallen and economic prospects have improved (hence, I think that the most effective monetary-policy action has been the most recent, because it has taken real rates below zero in spite of a general improvement in the economy). This is the reason for the strong correlation between the S&P 500 and 10-year breakeven inflation since 2009.

2.3. In Japan, the uptrend in breakeven inflation has cut the real interest rate at the 7-year point (the longest inflation-linked maturity available) from around 1% a year ago to around 0.15% today. That should have a stimulative effect on the economy. But will it cause JPY to fall, as effective monetary policy action in the US has caused USD to fall? I think that this is far from obvious. There is a certain money-flows aspect to central-bank asset purchases that means that it provides some upward pressure on asset prices; but I think that the main transmission mechanism is, again, via expectations. In the US, the risk of a central-bank response to any future inflation means that an asset-price rally that is kicked off by an improvement in economic data should be self-limiting in a weak recovery because markets’ anticipation of future inflation causes market interest-rates to rise with asset prices. Asset purchases are a signal to financial players that a central bank is committed to fighting deflation and that interest rates are unlikely to rise for some time, and hence, asset-price rallies are able to be sustained. In other words, it is the interaction of improving economic prospects and expectations that interest rates will remain low that causes a QE-driven boom. The boom encourages leveraged players to carry trade, using USD and JPY as funding currencies.

2.4. Will asset purchases in Japan have the same effect as QE in the US? I think not. Improving US economic prospects have an effect because the US is the world’s most important economy and because, since it was the driver of the 2008 crisis, it is used by many players as a proxy for the global economy. An improvement in the Japanese economy, other things being equal, ought not to have the same invigorating effect on global financial players. Further, the assurance that Japanese interest rates are unlikely to rise is hardly a change in the situation, and Japanese long-term rates do not tend to move very far even when the equity market rallies. So the signalling element of asset purchases, to the extent that it applies directly to the decision-making process of leveraged players, ought also not to have the same effect in Japan as it has in the US.

All of this has been an argument that there has not been an important-enough break in Japanese monetary policy to cause JPY to fall irrespective of what happens in the US. That does not mean that there will not be a global asset-price rally caused by other factors, or that JPY will not fall. But it does mean that the behaviour of USD/JPY will continue to depend on the two currencies’ relative attractiveness as funding currencies, and hence on the 2-year interest-rate spread.

Second, given the conclusion just reached, we need to think about US 2-year rates. Will they increase, and hence cause USD/JPY to rise? I am rather running out of time for today, so this will have to be a subject for tomorrow.